When electronics retailer China Paradise raised US$153 million in its Hong Kong initial public offering last October, few would have tipped the company to be swallowed by a competitor within 12 months.
Yet, at the end of July, market leader Gome Electrical Appliances confirmed it was taking over its third-placed rival in a US$678 million shares-plus-cash deal. Subject to shareholder approval, the acquisition should be completed by October.
"If you had asked me 12 months ago, I would not have said a merger was likely between two of the top players," said DBS Vickers’s analyst Mavis Hui.
While unusual, there is little doubt as to what triggered the move: the entry of US giant Best Buy into the China market. Best Buy is the Wal-Mart of consumer electronics and it is as keen to stock Chinese homes with white, black and high-tech goods as Wal-Mart is to supply the fresh, packaged and processed ones.
In May it paid US$180 million for a controlling stake in Jiangsu Five Star Appliance Co, giving it access to 136 stores.
"Best Buy’s strategic intention is obvious and all the major domestic players understand it," said Fan Cheuk Wan, head of China research at ABN-AMRO. "They expect Best Buy to accelerate its expansion into the China market through acquisitions and opening its own stores.
"The acquisition of Five Star was the catalyst for a move towards consolidation by the domestic players."
While Best Buy’s arrival may have pushed Gome into moving in on China Paradise, the battle for consolidation in the consumer electronics sector was raging well before the US retailer arrived.
The market is highly fragmented. Gome leads with a 9% market share, followed by Suning with 7.1% and China Paradise with 2.7%, according to the China Chain Store and Franchise Association.
In the last year, all three unveiled aggressive expansion strategies. China Paradise said it wanted to open 90-100 new Yolo-brand stores a year for the next three years while Suning targeted 100 openings per year and Gome 125.
The spate of new openings inevitably ate into profit margins and China Paradise felt it the most. With 52 of its 205 stores located in Shanghai and a 50% market share in the city accounting for 80% of total revenues, the company’s fortunes were effectively pinned to the most competitive retail environment in the country.
Thwarted by ambition
"The market had very high expectations for China Paradise when it came to the market," said Citigroup analyst Sandy Chen. "The story China Paradise was telling was that it was going to become a major national player by acquiring local players. But when the company’s financial results came out in April, it was found to have missed its operating profit expectation by a wide margin."
The share price was put under pressure and tomorrow’s major player became today’s vulnerable acquisition target.
That said China Paradise is likely to benefit from the deal. Company chairman Chen Xiao admitted the price was reasonable and, while he will no longer be in overall control, he is set to become CEO of the combined group with Gome founder Huang Guangyu as chairman.
Once united, the companies are expected to prosper on the back of a range of synergies. "The merger gives them a good exit opportunity," said DBS Vickers’s Hui.
In exchange, Gome gets better access to regional markets down the east coast where it has trailed its rivals. In Shanghai, Gome’s 33 stores, when added to China Paradise’s 52 outlets, create a 70% market share. At national level, the picture is equally rosy with the combined entity holding 501 stores to Suning’s 224.
Huang privately owns a further 196 Gome outlets, including the ones in Shanghai, which will eventually be incorporated into the listed company.
Faced with fast-consolidating local competition, Best Buy CEO Bradbury Anderson told Bloomberg in August the company plans further M&A in China. He was speaking in response to overtures from Beijing Dazhong, the capital’s leading electronics retailer.
Dazhong had agreed to a merger with China Paradise but the Gome takeover appears to have thrown this into doubt. Best Buy may be the best alternative buyer.
The US retailers is also thought to be in negotiations to buy Shandong-based San Lian Commerce.
"Even though it has acquired Five Star, Best Buy is still a relatively small player so further acquisitions are a possibility," said Citigroup’s Chen. "But Five Star and Sanlian focus on second and third-tier cities; I would think Best Buy would only target high margin tier-one cities to begin with."
As for the development of Best Buy’s own brand stores in China, it will take a long time to emulate the success of Wal-Mart and Carrefour. Both supermarket retailers have been operating in the country for about a decade, treading on – and sometimes over – the line drawn by the regulators. They both source a large number of products from China.
Compared to its global operations, Best Buy’s procurement volume in China is still relatively small.
"It has strong management expertise and strong supply chain management, but if Best Buy is to build a retailing business in China, it needs to establish relationships with suppliers," said ABN-AMRO’s Fan.
Supply-side strategy
According to Citigroup analyst Chen, Best Buy intends to build its supply chains by offering manufacturers a better deal than they are receiving at present.
As well as being forced to wait three months or so between delivery and payment on relatively small consignments of goods, suppliers also pay channel fees to the likes of Gome and Suning, securing preferential in-store promotion and display rights for their products. If the retailers are working to a gross margin of 8-9% of total sales, they can expect this to be boosted to 11-12% when channel fees are added on.
"Best Buy will probably shorten the payment turnover as well as taking more inventory and paying cash up front," said Chen. "We are seeing prices decrease, so it is risky for retailers who physically take up inventory, but Best Buy has large financial resources with which to do this."
Taking the inventory risk has served Best Buy well in the US where it boasted a 25% gross margin last year. Emerging markets are a different proposition, though. It remains to be seen, first, whether the US retailer pursues this model, and then, whether it can make money from it.
If it is to be a battle of economies of scale, then the outcome will in a large part be decided by who can grow fattest, fastest. Gome’s move for China Paradise, which comes in addition to a highly aggressive own-brand expansion strategy, is a bold statement of intent.
"All the top players in the electronics retail sector are run by private entrepreneurs, not state-owned groups," said ABN-AMRO’s Fan. "It’s a new retail format in China; only the strong can survive."